James Bevan: The MPC’s inflation hurdles
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James Bevan
For some time there’s been considerable divergence between Headline and Core inflation, and there remain considerable risks of deflation being exported from China if it materially devalues its currency later this year, along with the challenges of the sell down in global excess inventory and the ongoing surplus of supply relative to demand.
These known challenges have encouraged most commentators to be cautious on the outlook for inflation, and to assume that the Bank of England’s Monetary Policy Committee, led by Mark Carney, will only hike rates at some point in the distant future.
But with the recent weakness in sterling and the pick-up in commodity prices – and allowing for the tax measures in the Budget – it may well be that the UK’s period of low inflation is drawing to a close.
In terms of what we can expect for CPI inflation, the index does look set to edge up in the near term, with next week’s CPI perhaps coming in at +0.4%year on year (yoy) with petrol prices and import prices having ticked up.
Looking further out, the consensus numbers compiled before the Budget for key variables looked like this:
And this is what the progression of consensus forecasts looked like on before the chancellor’s Budget:
These numbers of course don’t include any allowance for the sugar tax, which the Office for Budget Responsibility (OBR) expects to add 0.25% to the CPI when it kicks in during 2018.
But if we were to assume that consensus numbers were roughly right before the Budget, then all other things being equal, we must now expect that CPI inflation will be back above the 2% target in 2018. In terms of year on year effect, the sugar tax impact will then fade during 2019 but, by then, domestic cost pressures may well be keeping CPI inflation at least at 2% anyway.
Looking back, the weakness in UK CPI inflation in the last couple of years has reflected the combination of declines in import prices and global commodity prices, subdued domestic pay growth, and the reduction of the previous tax-driven and regulatory-driven boost to prices (eg from tuition fees, petrol taxes, green taxes, etc).
Thus, from March 2013 to November 2015, sterling’s trade-weighted index (TWI) rose by 18.4%, pushing down on prices on imported items, with additional disinflationary pressures from the general weakness in global commodity prices and the overhang of global goods and services.
However, sterling’s TWI has now fallen by 8.5% from the November 2015 average, while oil prices are up by roughly $10 (30-40%) from their February 2016 low. As a result, the disinflationary effect of external factors is likely to fade in coming months – unless China opts for a significant devaluation in the second half of the year.
As an added issue, although petrol taxes will continue to be frozen this year, the chancellor announced a further rise in the Insurance Premium Tax plus the sugar tax for 2018 – and hence tax effects overall will begin to add to prices.
Wages are an unknown. Many assume that inward migration will stay quite high – capping pay growth – and that sterling will be little changed from current levels: both assumptions could be highly questionable in a Brexit scenario (and indeed are uncertain in a non-Brexit scenario).
It’s also widely assumed that the Monetary Policy Committee (MPC) will start a gentle tightening cycle around mid-2017, with the MPC steering much more by reference to inflation prospects than the spot inflation data.
For the last couple of years the MPC have been reassured by repeated undershoots of inflation (versus target and their forecast) and the subdued path of inflation expectations (partly reflecting low inflation outturns). If the period of low inflation ends, then the hurdle for MPC tightening will be much lower than recently and they may focus more on the persistent imbalances and the challenges of low productivity.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
